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Wednesday, January 4, 2012

Giffen Goods in Real Life

It's a basic pattern in economics, drummed into the head of every intro student, that when the price of a good rises, people tend to consume less of it; conversely, when the price of a good falls, people tend to consume more of it. Sure, there are some goods that are more responsive to changes in price than others. Sure, there may even be short-term exceptions like when a high price entices a few buyers looking for a high-status good. But even then, if the price keeps rising, the quantity demanded drops off.

But there's one exception to this rule, called a Giffen good, where a higher price causes demand for the good to rise. Until very recently, I had always told students when explaining this case that the example was a theoretical curiosity, without real-world application. I may have to change that.

The Giffen good was named by Alfred Mashall in his Principles of Economics, with the first edition published in 1890. Marshall explains the conventional wisdom that when the price of a good rises, quantity demanded falls, and vice versa. But he adds (Book III, Chapter VI): "There are however some exceptions. For instance, as Sir R. Giffen has pointed out, a rise in the price of bread makes so large a drain on the resources of the poorer labouring families and raises so much the marginal utility of money to them, that they are forced to curtail their consumption of meat and the more expensive farinaceous foods: and, bread being still the cheapest food which they can get and will take, they consume more, and not less of it. But such cases are rare; when they are met with, each must be treated on its own merits."

To spell out the underlying logic in modern terms, every price change has two effects on people: 1) it causes them to want to substitute away from what is now relatively more expensive and toward what is now relatively cheaper; and 2) it alters the buying power of their income. Most of the time, these two effects reinforce one another: that is, a higher price for a good makes people want to consume less of that good both because it's now relatively more expensive, and also because the higher price has reduced the buying power of their income.

But now consider what economists call an "inferior good," which is a good that people tend to buy more of as their income falls. Standard examples of an inferior good might be something like hamburger or oatmeal. Imagine further a very poor society, in which people spend a lot of their income on one source of food: in Marshall's example, that one source of food is bread; in the example often used long-ago when I was in college, it was potatoes in Ireland in the 19th century. Imagine that the price of that staple food rises. Usually, a higher price means less of that good consumed. But Giffen good is an inferior good, and the reduction in the buying power of people's incomes as the price rises (together with the lack of cheaper food alternatives, because for poor people this is already the cheapest alternative) means that they shift toward buying more of the good, rather than less.

Alfred Marshall attributed this idea to Robert Giffen, who was a financial writer who moved from journalism (including a stint in the early years of the Economist magazine) to being a government adviser on statistical questions. The attribution may be overly generous. As far as I know, the concept has not been found in any of Giffen's books or writings. But the terminology stuck, along with the idea that this was a very rare occurence. In Chapter 8 of my Principles of Economics textbook (and I encourage teachers and students of economics to check it out here), I wrote: "However, no study has ever found conclusive evidence of a Giffen good in the real world. A famous economist named Francis Ysidro Edgeworth summed up the situation regarding Giffen goods in this way in 1914: `Only a very clever man would discover that exceptional case; only a very foolish man would take it as the basis of a rule for general practice.`" [My notes to myself say that the Edgeworth quotation is from p. 9 of a book called ”On the Relations of Political Economy to War."]

Well, it seems that the development economics literature has now produced strong evidence of a real-world example of a Giffen good. The December 2011 issue of the Region magazine from the Federal Reserve Bank of Minneapolis has a lively interview with Esther Duflo about her work. The whole interview is worth reading, but one point that jumped out at me was her commentary about the evidence for a Giffen good. Here's Duflo, taking the possibility of real-world Giffen goods quite seriously:

"A recent example of this is an experiment by Rob Jensen and Nolan Miller, where they look at the effect on consumption of changes in the price of rice. If you decrease the price of rice, will people consume more rice or less rice? In the real world, it’s very difficult to know that because whenever the price of rice decreases, that’s the result of a combination of supply and demand factors, and isolating variation in the price of rice as purely exogenous is essentially impossible.So you need an experiment to know, and in fact they found something very interesting when they did this experiment in one place in China where rice is a very important part of the food basket for the poor. And they found that when the price decreased, people ate less rice, not more rice, which means rice is a Giffen good ...

"I think you can’t dispute the fact that rice, in this particular place in China, is a Giffen good.... Yes, it doesn’t mean that rice is a Giffen good here in the United States. I’m not interested in that question. But the fact that there is one Giffen good somewhere I think makes this interesting. It is incremental knowledge for how we think about the world and is very, very, very important for what we think about the poor and food. And in particular, in the policy domain, it shows that policies that subsidize the price of staples—which is quite common—might be counterproductive from the view of getting people to eat more. It still might be good for the poor, because they consume a lot of staples, and subsidizing a staple improves their income. But if the objective was to make people eat more, that’s not necessarily the way.

"That does not mean that it would be true in India, but the very fact that there is this possibility means that we want to investigate this question more. And we can try a similar experiment elsewhere to see in what conditions this will reproduce. With a Giffen good, the advantage is that we have a very established theory that helps us think what’s likely to be a Giffen good. It has to be something that is a very big part of the budget so that the income effect is large. And it must be an inferior good. That gives us a sense of, in another place, how would we go about looking for a good that’s likely to have the same characteristics? Maybe there are no Giffen goods here because no goods have those characteristics. But maybe if we went to Ethiopia, it would be whatever is the staple food there. We can see what’s the share of this staple in people’s budgets and get some idea of what we are looking for."

The research paper to which Duflo is referring is Robert Jensen and Nolan Miller. 2008. “Giffen Behavior and Subsistence Consumption.” American Economic Review 98 (4): 1553-77.